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Tata's Gamble: Triumph or Nemesis?

Published by MAC on 2007-03-15

Tata's Gamble: Triumph or Nemesis?

C.P. Chandrasekhar, One World South Asia

15th March 2007

Billed by one financial paper as the first step in a Global Indian Takeover, the acquisition of Anglo-Dutch steel major Corus by the Tata group is as much about upper-crust India's new nationalism as it is about corporate strategy. Tata's victory in the final head-to-head auction against Brazil's Companhia Siderúrgica Nacional (CSN) is undoubtedly a major event in the country's corporate history. The Tata bid, which requires the group to pay $13.2 billion to acquire Corus, would when completed make the company the fifth largest steelmaker in the world and the Tata's India's largest business group. This is not surprising given the estimate made by data consulting firm Dealogic, that this acquisition is nine times higher than the largest previous acquisition of a foreign firm by an Indian company.

It is to be expected that much thought went into the decision made by Tata Steel to raise, in stages, the initial bid of 455p a share by 33.6 per cent to 608 p per share, in order to clinch the deal. But there is reason to believe that the prospect of making the Tata brand a symbol of India's national pride played a role. In an interview to the Financial Times Ratan Tata reportedly said: ''We all felt that to lose would go beyond the group and it would be an issue of great disappointment in the country. So on the one hand, you want to do the right thing by your shareholders and on the other hand, you did not want to lose.''

As the euphoria over this being a ''national'' victory wanes the question that would remain is whether the price offered by Ratan Tata to emerge as the country's economic hero may be too high for comfort. Besides being close to 34 percent higher than the company's original bid, the price paid by Tata is much higher than that in other recent acquisitions in the steel industry. It is even higher than the price offered by Mittal in the highly controversial, much larger ($32 billion) takeover of the better performing Arcelor.

B.Muthuraman, the managing director of Tata Steel, made an attempt to justify the price paid, saying that at $720 per tonne of installed capacity it was less than the recent average for acquisitions in the industry, and about a half of what it would take to set up over an extended period of time similar capacity on a greenfield basis. But these arguments are unlikely to convince the sceptics. According to a London-based steel analyst quoted by the Financial Times, 450p was ''a stand-alone fair value for the company'', with anything beyond that requiring returns from new synergies.

It is indeed such synergies that the Tata's are relying on. The group is betting on the fact that it has advantages as an integrated steel producer that has its iron ore sources which can produce steel at low cost. Corus, on the other hand, has the technology and the access to markets to fabricate and market high quality steel products. The essential strategy is to ship iron ore and/or low-cost crude steel to the Corus' plants in Europe, which would use their technological know-how to turn this low-cost raw steel into finished products that can be sold to customers close to them. Tata's has been seeking to pursue a similar strategy through its much smaller acquisitions of NatSteel in Singapore and Millennium Steel in Thailand.

There are, however, a host of constraints on making this strategy a success. The first of these is physical. Tata would need to expand its capacity substantially in order to be able to ensure adequate supplies of crude steel to Corus. Corus can produce about 18 million tonnes of steel a year. According to one estimate, Corus could absorb about 13 million tonnes of crude steel from Tata. But as of now Tata's steel producing capacity stands at just 5 million tonnes. Tata already has plans to expand capacity to 25 or 30 million tines. But that would take time, going up to 2015. In the meantime, the Tatas may choose to export iron ore, by acquiring more mining capacity, but that involves a cost and would imply that the cost savings and the returns to Tata Steel from producing crude steel in India would not materialize.

The second problem is ensuring that Corus can find markets large enough to keep its capacity utilized. The demand for steel in Europe has turned sluggish in recent years as a result of relatively slower growth in steel-using industries like construction, automobile production and the white goods sector. In 2005, steel demand in the European Union, which amounts to around 15 per cent of global demand, reportedly fell by 1.5 per cent. While this may reverse itself, the benefits may be neutralized by imports from low cost regions, including China where capacity is reportedly expanding faster than demand. Overall, expectations are that demand growth would be low even if not negative. Philippe Varin, Corus's chief executive, is reported to have said that conditions concerning steel supply could be ''more difficult'' for Corus in 2007 on account of increasing imports into Europe of steel from other regions, including China in particular. Such competition can depress steel prices in the region, affecting profits.

In a scenario of that kind, Corus would be particularly affected since within Europe it ranks behind steel majors such as Arcelor and ThyssenKrupp of Germany in terms of performance. And European companies are not at the top of the global performance league table. Part of the reason why Corus was up for sale is that despite a turnaround from a difficult position a few years back, it has seen profits slip by 15 per cent during the first nine months of 2006, due to lower steel prices. However, stronger markets had helped the company record a significant improvement in profitability in the quarter ending September 2006 as compared with the corresponding period of the previous year. This improvement notwithstanding, the challenge faced by the Tata's after the takeover is substantial given the high price that has been paid for the acquisition. The final bid price values Corus at nine times earnings before interest, taxation, depreciation and amortisation from continuing operations for the year ending September 2006.

The acquisition is also a burden on the Tata's because the turnover of Corus almost equals that of the Tata group as a whole, with substantial revenues by Indian standards from three principal lines of business: information technology, automobiles and steel. Though cash-rich because of profits from these areas, Tata would have to stretch itself to finance the acquisition. While details on how Tata Steel plans to finance the acquisition are still unclear, expectations are that the company would have to put up anywhere between $4 and $5 billion as equity in a special purpose vehicle that would be used to acquire Corus. Preliminary reports suggest that the company plans to fund the acquisition on a 53:47 debt-equity basis, with the exposure of Tata Steel likely to be in the region of $4.1 billion, which too will be a mix of debt and equity. While a preferential share issue by Tata Sons and surpluses from group companies may go a part of the way in generating these finances, a sum of around Rs.20,000 crore is not easy to come by. Tata is likely to have to leverage its own equity investment in the special purpose vehicle.

Speculation is rife that Tata Steel's debt-to-equity ratio could rise above 100 per cent from its current level of about 15 per cent. On top of this the special purpose vehicle will have to raise debt against Corus's future cash flow to pay for the acquisition. But this may require some guarantee from the side of the Tata's.

All this could mean that the Tata group itself may turn vulnerable. In fact Australian financial consultancy Macquarie had reportedly estimated that the deal would be earnings per share neutral for Tata Steel at 540p per share, after which it would begin to weigh on the profits of the Indian steel maker. Tata's has in recent years combined modernisation and retrenchment with access to low cost iron ore to emerge a high margin steel producer. But the burden of this deal and the time likely to be taken to bring its benefits to fruition may damage the company.

However, in a phase of India development when the government has turned investor friendly, maybe the company can count on support from the Indian state. When the deal was announced Finance Minister P. Chidambaram declared that the government ''will be ready to help Tata's, if they have any request, to complete the Corus transaction,'' though he qualified his statement by saying that it would only be ''general help'' in the nature of facilitating ''clearances or approvals or permissions'' within the country. But there may be more to this support than yet declared, which could explain the gamble that the Tata's have taken.